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Question 3

An investor believes that there will be a big jump in

a stock price, but is uncertain as to the direction. Identify five different strategies the investor can follow. Compare and explain the differences among them.


Question 4 (10 marks)

An investor has a bearish view of the stock, which he would like to take advantage of by constructing an option 'spread' strategy. Your goal is to maximize the initial cash inflow using this strategy. Suppose there exists the following options on the same underlying share of the stock. The share is currently trading in the market at $40.


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(a)   Which options would you use for your spread strategy? Explain your answer.

(b)  Construct a payoff table for your option strategy. Show the payoff for individual options you use and the total payoff of the spread.

(c)   Draw a payoff diagram for your strategy, show the maximum and minimum level of payoff and strike price(s).


Question 5

A stock price follows geometric Brownian motion with an expected return (µ) of 15% and a volatility (σ) of 30%. The current price is $45. (Tip: make use of the ln(ST) distribution)

(a)   What is the probability that a European call option on the stock with an exercise price of $50 and a maturity date in six months will be exercised?

(b)  What is the probability that a European put option on the stock with the same exercise price and maturity will be exercised?

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